Is it time for your retired clients to buy that vacation home they have always wanted?
While there is a great deal of emotion that accompanies real estate purchases, the analysis from a financial standpoint basically comes down to a comparison of the costs of renting versus buying. Prior to the economic meltdown, it was clearly far cheaper to rent than it was to buy, which was probably a good indicator of the housing bubble.
But today, in many places that are popular with retirees, such as Florida and Arizona, it is getting closer to a toss-up, and the emotional value placed on ownership also closes the gap. If your clients are in the market for a second home, here is a quick guide to help you figure out whether buying makes more financial sense than renting.
Let’s assume that your clients are considering purchasing a $300,000 vacation home. Also assume the rental costs for a similar home in the area are $3,000 per month.
If the client pays cash for the home, the client essentially is removing $300,000 from their retirement savings, which will reduce their anticipated distributions in retirement. At an assumed 5% distribution, the client is forfeiting $15,000 of distributions each year. But in exchange for that $300,000, the client gets a house that he or she can use without paying rent.
So does it make more sense to buy the property and eliminate the rental costs, or keep the money invested and use the distributions to pay the rent? The answer depends on how much the client intends to use the home.
Let’s assume that the client plans to use the home for three months a year. Under these facts, renting is much cheaper than buying. If the client keeps his $300,000 invested, he or she could use the $15,000 of distributions to pay the $9,000 of rent and end up $6,000 ahead.
But what if your client wants to rent for 5 months? At $3,000 a month, it would cost $15,000 to rent. So if the client took $300,000 of retirement savings and bought the house, he or she would forfeit $15,000 of distributions but avoid the $15,000 in rental costs, which looks like a break-even deal.
The analysis, however, has to go a bit deeper. If the client decides to purchase the property, he or she will become responsible for maintenance, insurance and taxes, or the ownership costs, on the home. While each region of the country is different, a good estimate is that over the long term, these ownership costs would run about 2% to 3% of the price of the home each year. This may not be the case every year, but at some point, the roof needs to be replaced, the house needs painting, sewer lines break, and the list goes on.
So let’s use 3% to be a bit more conservative. This means it would cost about $9,000 a year in extra ownership costs for the property. That brings the total ownership cost to $24,000 ($15,000 in forfeited distributions and $9,000 in ownership costs). So it still looks to be cheaper to rent for 5 months at $15,000 compared with the total cost of ownership at about $24,000.
If we bump the rental period to 6 months, we are getting closer. Six months of rental would cost about $18,000 for the year, and ownership would be about $24,000. While it still looks like renting is cheaper, to be fair, we have to factor in some intangible value for the client, plus some opportunity for long-term appreciation of the property.
The intangible value comes from a sense of permanency associated with owning a home. If a client is going to live someplace for half the year, he or she probably would like to be in the same location. This allows the client to develop and maintain friendships, which can of course add greatly to his or her quality of life. Owning the home also allows the client to furnish the home as he or she desires, instead of taking the chance on a new rental property each year.
It is hard to put a value on it, but let’s say your client indicates the sense of permanency is worth $3,000 a year. This brings the cost of ownership down to $21,000, versus the cost of renting at $18,000.
Then there will probably be some long-term capital appreciation on the home. Let’s be conservative and assume 3% long-term appreciation, which would be about $9,000 a year. While the appreciation is a non-cash benefit, at some point, the client could anticipate realizing those gains. This in theory brings the long-term cost of ownership below the cost of renting.
At the end of the day, it is really a lifestyle choice for clients. Clients could of course rent forever, which generally provides more flexibility and less risk. But for the clients who want to spend a good portion of each year at a second home, the decline in real estate prices, plus the benefits of ownership, may justify purchasing instead of renting.
